YELP: It Has No Clear Path To Profitability

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Local reviews site Yelp is set to price their upcoming IPO tonight. According to a report in the Wall Street Journal, it will sell 7.15 million shares at a price of $12 to $14. That would value the company at $838.6 million at the high end of that range.

As you probably know by now: Yelp is not currently profitable. Last year Yelp incurred an operating loss of $16.2 million on revenues of $82.3 million.

Is this a cause for concern? Yes and no. There is nothing inherently wrong with running losses during a period of heavy investment. However, Yelp's losses fell less than 1 percent as a percentage of revenue from 2010 to 2011 and are surprisingly large considering the company's 74 percent year-over-year growth.

We believe Yelp will face a difficult path to profitability in the coming years.

Yelp and the “Network Effect”

If Yelp wants to build a profitable business in a very competitive market, it will need a defensible comparative advantage.

Our platform helps people find great local businesses to meet their everyday needs. As more people use our platform, more of them write reviews. Each review that a user contributes helps expand the breadth and depth of the content on our platform, in turn drawing in more consumers. This increase in consumer traffic improves our value proposition to local businesses as they seek low-cost, easy-to-use and effective advertising solutions to target a large number of intent-driven consumers.

In other words, Yelp thinks its depth and breadth of customer reviews create a network effect.

Yelp first enters a market and begins creating profiles for local businesses (what they call ‘claimed business locations’). Users then begin to write reviews, ultimately creating a snowball effect until Yelp becomes the definitive guide to local businesses in their market. At this point, Yelp pitches itself to local business as a cheap and effective way to reach their local audience.

Although it may sound a bit far-flung in theory, this can and has worked in certain markets. In San Francisco, its first and most developed market, Yelp is widely accepted as the most effective way to search and find local businesses. Furthermore, by enabling hyper local neighborhood searches, Yelp is usually better to look for local businesses than Google.

At its best, the network effect produces a product akin to a crowd-sourced Zagat (you might want to keep that analogy in mind). While it's easy to discard the reviews of a few picky or petulant customers, it is hard to discount the broad consensus of over 100 reviewers (as is commonly the case for businesses in Yelp’s most developed markets).

However, it remains to be seen if Yelp will be able to duplicate this success in other markets. They have seen impressive year-over-year growth in several key metrics: reviews (64 percent), unique monthly visitors (67 percent), claimed local businesses (97 percent), and active local advertisers (118 percent). Nonetheless, despite these gains, Google still accounts for 75 percent of Yelp’s traffic. In other words, Yelp has not yet succeeded in becoming a stand-alone web destination. Further complicating Yelp’s expansionary growth strategy is the increasingly fierce competition it faces in the local advertising market from the hand that feeds it, Google.

The 800-Pound Google in the Room

Google and Yelp have had what can at-best be described as a contentious relationship. In 2009, Yelp walked away from an all-but-signed agreement to be acquired by Google for more than $500 million. Google reacted by making clear its determination to crush Yelp with all the fury of a scorned lover. They have developed their own competing review service, Google Places, and more recently purchased restaurant review and guide source Zagat.

Other companies are getting into the mix too. Foursquareoverhauled its website in November to emphasize search and discovery of local businesses—a clear challenge to Yelp. Users can now search a map to find local businesses that are trending, on a user’s list, offering a special, and can even receive recommendations based on time and day. Groupon and Living Social can also be considered competitors as daily deals are a local advertising product of sorts. Furthermore, local advertising has started migrating onto Facebook as well.

What are the stakes? In a word: huge. According to BIA/Kelsey, a market intelligence firm, local businesses spent approximately $133.2 billion on advertising in 2010, only $19.6 billion of it online. Furthermore, 95% of all consumer spending is local. As local business advertising continues to migrate online, the dominant player in the local review market will do very well.

The $19.6 billion question is then: will local businesses devote their small advertising budgets to Yelp or other players like Google and Groupon? Which is most effective in driving new business? The answer, paradoxically, may be neither for some businesses. Why? Services like Yelp have the power to turn the out of the way taco stand into an overnight sensation, effectively undercutting Yelp’s own advertising pitch. Why would a company need to advertise if their own customers are already doing it for them?

The Rocky Road to Profitability

As discussed earlier, Yelp's operating losses have barely narrowed in the past year. Given their eye-popping revenue growth, it is worrisome that operating losses still stand at 19 percent of revenue. Why? Largely as a result of its sales and marketing expense, which ate up 65 percent of its revenues last year (see chart outlining revenue and expense growth to the right).

As part of its expansionary growth strategy, Yelp is clearly investing heavily in its sales effort. And so sales and marketing will continue to drag on the company’s bottom line as it invests in the top line. It is not clear, however, whether they will be able to cut this expense without sacrificing their revenues. In other words, there is not a clear path to sustainable profitability (see chart below outlining quarterly revenues and operating losses).

Yelp S-1

Finally, and most worrisome, it does not appear that Yelp’s core business of local advertising has been consistently growing in line with its huge increase in local advertising accounts. Quarterly local advertising revenue per active local business account has fluctuated wildly and appears to actually be trending downward over time (see chart below with red trend line).

In other words, Yelp is making less money per advertiser in the most recent quarter that it was in the first quarter of 2010. While some of this is surely attributable to the growth in accounts, it is nonetheless a little worrisome as it may indicate that advertisers are not satisfied with their return on investment. The dollar drop is not devastating in absolute terms, but it is a foreboding trend as Yelp attempts to scale revenues and achieve a sustainable profitability.

Yelp S-1

There may be some good news though. If the network effect does in fact work, revenues will follow user adoption. Yelp’s explosive growth in user adoption over the past year would, therefore, be indicative of strong future revenue growth.

In other words, the bull's case for Yelp goes something like this: in its most established markets, Yelp is the dominant local reviews site; user-generated reviews give Yelp a network effect, which means over time it should get established in many more markets; as it does, it will be able to sell its advertising to local businesses profitably.